reCap BLOG

As discussed in my previous post, despite robust global and US economies inflation has remained soft relative to expectations. The Fed’s elusive 2% target has resulted in an unhurried approach to tightening US monetary policy, but certain inflationary metrics are materializing. Given the symbiotic relationship between interest rates, asset prices, and the strength of the broader economy, we believe it’s important to keep a pulse on inflation.

To be clear, moderate inflation is typically considered a good thing as it supports a growing economy, but too much can signal overheating and may influence the Fed to raise rates quickly, resulting in a ripple effect throughout the economy.

We witness several factors which indicate inflation is starting to pick up steam:

Employment & Wages - The US labor market is the tightest it has been since 1969 (Source: CNBC) and as a result, company management is finding it harder than ever to source and hire quality talent, citing this as a top concern for 2018 (Source: Conference Board). Given these supply-demand dynamics and fiscal stimulus in the form of tax cuts, wages & salaries have started to rise at last, registering their biggest increase in 11 years during Q1 2018 (Source: CNBC). As reflected in the chart below, small business compensation levels have seen recent unexpected jumps to the upside.

Source: NFIB

Consumer & Producer Prices – Two indices measured by the Bureau of Labor Statistics and Institute for Supply Management respectively, the Producer Price Index (PPI) and ISM Price Index, are showing signs of acceleration. March figures for the two indexes came in higher than expected, with 17 industries reporting increased raw materials prices (Source: ISM and BLS). Additionally, two previous inflation suppressors, the healthcare and airline industries, saw an uptick in price during Q1'18. American Airlines for example forecasts a 30.1% increase in its fuel expense for 2018 year-over-year, citing increased oil and steel prices (Source: Forbes). Additionally, the New York Fed’s UIG (underlying inflation gauge) seen in the title chart has historically forecasted inflation better than traditional measures. The latest UIG readings forecast a continued rise in inflation over the next year or so.

Tariffs & Sanctions – In March, The U.S. Department of Commerce enacted new tariffs on steel and aluminum, following those approved on imported solar panels in January. Though we do not believe this will lead to a full-blown trade war, companies and their margins are feeling the pressure. Several blue-chip companies including Caterpillar, Ford, and Whirlpool have already reported consequent raw materials price inflation having an adverse effect on earnings (Source: CNBC). Further, the possible renewal of US sanctions on Iran would constrain the country’s ample oil exports. Already 15% above mid-February lows, this development could jolt oil prices even higher, burdening producers and consumers alike.

As stated previously, we believe risk of recession in the near-term is low, but inflationary pressures described herein exist as potential headwinds to continued economic expansion, and tailwinds to the Fed’s contractionary agenda.

Title Chart Source: Federal Reserve Bank of New York

S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market.

Investors cannot invest directly in an index. Past performance is no guarantee of future results.

A recession is a significant decline in activity across the economy, lasting longer than a few months. It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP).

Volatility is a statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index.

Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth.

The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. The Federal Reserve System is composed of 12 regional Reserve banks which supervise state member banks. The Federal Reserve System controls the Federal Funds Rate (aka Fed Rate), an important benchmark in financial markets used to influence the supply of money in the U.S. economy.

Underlying Inflation Gauge (UIG) is a measure of underlying inflation produced by the Federal Reserve Bank of New York which is derived from a broad data set extending beyond price series to include a wide range of nominal, real, and financial variables by using a dynamic factor model.

Consumer Price Index (CPI) measures prices of a fixed basket of goods bought by a typical consumer, widely used as a cost-of-living benchmark and uses January 1982 as the base year.

The Institute for Supply Management (ISM) is responsible for maintaining the Purchasing Managers Index (PMI), which is the headline indicator in the monthly ISM Report on Business. The ISM is a non-profit group boasting more than 40,000 members engaged in the supply management and purchasing professions.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts or Lincoln Investment.

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